Balancing for recovery

While institutional investors have reduced the risk profile of their portfolios, Gerben Lagerwaard of State Street Global Advisors expects economic conditions to improve in 2023.

2022 was a difficult year for investors worldwide. The global economy is struggling with inflation, central bank tightening and expectations of lower economic growth. For 2023, we expect market uncertainty to persist for some time, leading to a difficult path to recovery with a wide range of possible outcomes, with the timing of recovery largely dependent on central bank policies.

With the global economy slowing rapidly and the current monetary tightening cycle rolling out, we are on the brink of an overburdened situation. Against this background and in a challenging geopolitical environment, we expect a turning point in the next 6-12 months, after which conditions may improve.

We recognize that there is still a turbulent road ahead with volatile interest rates and inflation, but we also see positive signs and expect the first signs of recovery in 2023.

Risk adjustments

Due to the volatility, Dutch institutional investors have adjusted the risk profile of their portfolios down during this year. One of the shifts in allocation is the growing interest in indexed bond funds. In periods of turbulence and downward market movements, the cost-effectiveness and transparency of indexed bonds are increasingly appreciated by Dutch institutional investors.

Another factor reflecting the declining risk appetite is the growing aversion to China due to the unpredictable situation in the country. For 2023, we expect that Dutch institutional investors’ interest in interest rate solutions will increase further and that the cautious positioning towards China will continue.

Investors seek downside risk protection by preparing their portfolio for different scenarios. A liquidity buffer provides protection and extra clout to take advantage of an improving economy. Longer-term bonds, especially government bonds and investment grade credit, have returned to seemingly attractive levels, unless inflation continues, which we do not expect. A weaker dollar provides better risk-adjusted return opportunities for non-US assets.

“Investors seek downside risk protection by preparing their portfolio for different scenarios”

Monetary tightening hurts emerging markets

While the current cycle of monetary policy tightening is running at top speed, the global economy is decelerating rapidly, especially in developed markets. Central banks’ efforts to curb inflation inevitably hurt growth and employment, but for now this is an acceptable trade-off: economies will experience some short-term pain in exchange for long-term gains. Markets experience some short-term volatility in exchange for long-term stability.

The global macroeconomic and geopolitical environment remains particularly challenging for emerging markets, particularly in economies that are more vulnerable to price shocks in energy, food and commodities. Combined with the tight cycle, the continued slowdown in global demand and tensions between the US and China, growth prospects for emerging markets are difficult to assess at this time.

But recovery is on the way

State Street’s central assumption is that despite these vulnerabilities, conditions are likely to improve at some point in 2023. A key indicator of recovery is the decline in inflation. The drop in Dutch inflation from 14.3% in October to 9.9% in November, as calculated by Statistics Netherlands, is a cautiously positive sentiment.

We are optimistic that global inflation will also decline visibly and significantly over the next six months. This, in turn, should lead to a reconsideration of how long policy rates should remain in a deeply restrictive range.

“We are optimistic that global inflation will decline visibly and significantly over the next six months”

As markets adjust to this change in outlook, the dollar’s appreciation is likely to take a breather, which should support financial stability in emerging economies.

In any case, we continue to look for signs of a cautious recovery. Until then, caution, patience and vigilance are required.

Gerben Lagerwaard is head of Europe institutional at State Street Global Advisors

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